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The Exchange Rate Targeting of Central Banks Revised: The Role of Long-term Interest Rates

  • Lahtinen, Markus
  • Mäki-Fränt, Petri
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    Using a New Keynesian macro model, the paper reconsiders the question, whether the central banks should directly respond to exchange rate movements. It is assumed that the transmission of monetary policy to output is carried out by the long-term interest rate, which is determined as a sum of expectations of short-term interest rates and a non-negligible term premium. According to the results, the central banks could gain from stabilizing the exchange rate movements more than suggested in the previous literature. The welfare gains are more clearly seen in the reduced volatility of inflation than stabilization of output, however.

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    File URL: http://www.economics-ejournal.org/economics/discussionpapers/2007-28
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    File URL: http://econstor.eu/bitstream/10419/17951/1/dp2007-28.pdf
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    Paper provided by Kiel Institute for the World Economy in its series Economics Discussion Papers with number 2007-28.

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    Date of creation: 2007
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    Handle: RePEc:zbw:ifwedp:5733
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    1. Leitemo, Kai & Soderstrom, Ulf, 2005. "Simple monetary policy rules and exchange rate uncertainty," Journal of International Money and Finance, Elsevier, vol. 24(3), pages 481-507, April.
    2. Kilian, Lutz & Taylor, Mark P., 2003. "Why is it so difficult to beat the random walk forecast of exchange rates?," Journal of International Economics, Elsevier, vol. 60(1), pages 85-107, May.
    3. Svensson, L.E.O., 1998. "Open-Economy Inflation Targeting," Papers 638, Stockholm - International Economic Studies.
    4. Taylor, John B., 1998. "The Robustness and Efficiency of Monetary Policy Rules as Guidelines for Interest Rate Setting by the European Central Bank," Seminar Papers 649, Stockholm University, Institute for International Economic Studies.
    5. Andrew G. Haldane & Nicoletta Batini, 1998. "Forward-Looking Rules for Monetary Policy," NBER Working Papers 6543, National Bureau of Economic Research, Inc.
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